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If I have $10k in an IRA, trade stocks with it until my retirement it accumulates (with no additional contributions) to $100k and withdraw it, how are the $90k gains taxed? How does this differ from a Roth IRA?

If gains are taxed the same between IRAs and Roth IRAs I can only see regular IRAs as better, because you effectively can compound gains on the taxes you haven't paid yet for the next n years until retirement, which should accumulate to a much higher amount than the amount saved (or lost) from the difference in tax rates.

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The idea behind a Roth IRA is taxes will go up in the future so you are best off paying less in taxes now than in the future, which is why Roth IRAs are contributed to with post-tax dollars whereas traditional IRAs are contributed to with pre-tax dollars. The theoritical advantage comes when you want to withdrawal your money. With the traditional IRA, when you withdrawal money, you pay ordinary income tax on all withdrawals. With a Roth IRA, all withdrawals (after the age of 59 1/2) are tax free, including any gains you may have made.

To illistrate, with a very simple example, assume you make $50,000 and your IRA grows at 5% for 40 years.

Contribution

Traditional IRA - $5,000
Roth IRA - $3,750 ($5,000 after taxes)

Totals after 40 years

Traditional IRA - $604,000
Roth IRA - $453,000

Withdrawal equally over 15 years

Traditional IRA - $604,000 / 15 = $40,266 * 75% (25% tax) = $30,200 / year
Roth IRA - $453,000 / 15 = $30,200/ year

First, this was not a contrived example and I was surprised the numbers worked out this way. Second, as you can see with this example there is really no advantage either way unless you by into the theory of higher taxes in the future.

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    No, it's not contrived at all. You ignore growth during the 15yr withdrawal phase but that really doesn't change the numbers. What you missed is that the earners (I assume MFJ) may have taken the pretax IRA off the top at 25%, but with only $40K/yr at retirement, would pay about $2245 in federal tax, a marginal 15%, but first a standard deduction, exemptions, and some 10% bracket. $2245 vs the $10,000 you show. – JoeTaxpayer Aug 10 '12 at 13:30
  • @JoeTaxpayer, you are absolutely correct and I have a feeling there is a lot that I could have gone into and missed, but I was going for the general overview just to give a basic idea. – ninja coder Aug 10 '12 at 13:52
  • Let me ask the rhetorical question - what percent of folk do you believe will actually be able to retire at a level where their income is higher than when they worked? If rates do go up, do we really believe the 15% bracket will be hit, or just the higher brackets? There are many unknowns, which makes both our observations valid and worth reading. – JoeTaxpayer Aug 10 '12 at 14:09
  • This also missed the Clark Howard point that will will put $5K in after taxes to a Roth, thereby "saving more" each year. Your numbers are right, but the human psychology might give the Roth an edge for some people. – MrChrister Aug 10 '12 at 16:19
  • Yes Mr Christer, the Roth is "Denser" with a graph and all - rothmania.net/the-density-of-your-ira – JoeTaxpayer Aug 10 '12 at 22:04
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All money distributed from a Traditional IRA to which no nondeductible contributions have been made is taxed as ordinary income. It does not matter if you think of the money as the original contribution or gains; the taxation is the same. Money distributed from a Roth IRA is tax-free. In either case, penalties apply if the distribution is premature.

  • Actually, Roth IRA contributions (not earnings) can be withdrawn anytime without penalty in most circumstances. – Greg Aug 10 '12 at 15:29

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